The Yield Curve and Recessions: How the Difference between Long- and Short-Term Interest Rates Anticipates Recessions in the United States and Other Industrial Economies
Estrella, Arturo, The International Economy
In the late 1980s, economists became aware of a remarkable phenomenon: every U.S. recession since 1950 has been preceded by a sharp drop in the yield curve spread, the difference between long- and short-term interest rates. By the time this result was published in a scholarly journal in 1991, the regularity had been confirmed by yet another recession. The empirical relationship is remarkable both in its consistency over decades and in the long forecast horizon of about a year. Moreover, subsequent work has uncovered similar patterns in other industrial economies, with particularly strong results for Germany and Canada.
These regularities suggest a simple way of gleaning accurate and timely forecasts from financial market data. A convenient rule of thumb is that the monthly average difference between 10-year and 3-month Treasury rates has turned negative (the yield curve has inverted) before every recession since 1960. The only seemingly false signal--an inversion in 1966--was followed by a well-documented "credit crunch" and a marked drop in industrial production.
Another way to interpret the yield curve signals is to apply a statistical model that converts the 10-year minus 3-month spread into a probability of a recession twelve months later, as shown in the chart. When the yield curve is steep and the spread is high, the probability of a subsequent recession is close to zero and not very sensitive to changes in the spread. As the spread approaches zero, the probability rises more rapidly. The shaded region represents the range of the spread for which the probability of recession exceeds 30 percent, which has been the case prior to every recession since 1960.
Why does this consistent relationship exist? Two important factors are monetary policy and market expectations of real activity and inflation. A tightening of monetary policy is normally associated with a rise in short-term interest rates. If the higher levels are expected to persist for some time, long-term rates tend to rise as well. However, if the change is not viewed as permanent, long-term rates do not rise as much and the yield curve flattens. Of course, another consequence of monetary tightening is a subsequent slowdown in economic activity, and the predictive result follows.
An alternative way to look at the relationship is to focus on market expectations. Interest rates are determined in part by the real demand for credit and by expected inflation. A rise in short-term interest rates may be a harbinger of a future slowdown in real economic activity and demand for credit, putting downward pressure on future real interest rates. At the same time, slowing activity usually leads to a decline in expected inflation. Given this interpretation, future short-term rates may be expected to decline, which tends to reduce current long-term rates and flatten the yield curve. Once again, the observed correlation between the yield curve and recessions follows.
Is it the level or the change in the yield curve spread that matters? For recessions, it is clearly the level. We can see this in the chart, which shows that a given change in the spread can have a very different impact, depending on the initial level of the spread. In this connection, note that the Conference Board, which added the yield curve spread to its index of leading indicators in 1996, announced in June 2005 that it will adjust its procedures so as to focus on the level and not on the change.
Does it matter if the yield curve flattens as short rates rise or as long rates decline? Since it is the level and not the change that matters, the immediate source of the change does not affect the signal. …